Curso Keynes

READINGS FOR UNAM LECTURES:

FINANCE IN ECONOMIC THEORY


APRIL 2006


I: Extracts from J. Toporowski THEORIES OF FINANCIAL DISTURBANCE Aldershot: Edward Elgar 2005.








Introduction

The macroeconomic consequences of finance are a neglected part of financial economics. This may be in part because the professional duty of central bank economists condemns them to measuringthe efficacy of monetary policy, and that of economists employed in banks and financial institutions condemns them, at worst, to advertising their employers’ wares and, at best, to projecting asset prices, calculating optimal portfolios, and anticipating the policy of the central bank. Such neglect comes in spite of the domination of the markets by large collective investing institutions (pensionfunds, insurance companies and investment funds) that has emerged in the second half of the twentieth century. Although such institutions are more amenable to study than individual investors, their activities in many cases have shown that their bureaucratic rationality in the face of their ignorance is little advanced on that which Keynes criticised seventy-five years ago:
‘The ignorance of eventhe best-informed investor about the more remote future is much greater than his knowledge, and he cannot but be influenced to a degree which would seem wildly disproportionate to anyone who really knew the future, and be forced to seek a clue mainly here to trends further ahead. But if this is
true of the best-informed, the vast majority of those who are concerned with the buying and selling ofsecurities know almost nothing whatever about what they are doing. They do not possess even the rudiments of what is required for a valid judgement, and are the prey of hopes and fears easily aroused by transient events and as easily dispelled.’1
This judgement is perhaps severe, in view of the huge academic and professional investment in methods of calculating optimal investmentportfolios since those words were written. But, as I have argued in The End of Finance, when the markets are being inflated, it does not take much rationality to make money. Such calculation, by keeping attention focussed on market outcomes and their shifts over time, fails to pay due attention to the sequences of transactions outside the markets that bring about such outcomes. Calculating optimalportfolios provides reassurance in the face of the ignorance that Keynes described. This practice narrows down the scope of risk, or unpleasant surprise, to a fall in asset prices.
Behind this pre-occupation with obvious phenomena is a particular methodological predilection, the rise of formalism in economics (see Backhouse and Laidler 2003). Formalism is loosely associated with the conversion ofeconomic analysis into mathematical models. However, while mathematics has a place in economics it cannot substitute for the study of how markets work. Keynes rightly criticised Irving Fisher for confusing what an equation told him would happen with what would happen in the real world.2 It is not enough to have an equation relating two variables: it is necessary also to have an explanation of howthe two variables are brought into such a relationship in the economy. When such a relationship includes a presumption of equilibrium, which financial models need for technical reasons of determinacy, the outcome is a presumption of stability, which may not exist in the real world3. Finance literature allows for instability of variables, and even extended ‘departures from equilibrium’ as in NewKeynesian-type information cascades, or behavioural finance. But these models provide different time paths for variables, rather than showing the mechanisms by which financial instability is conceived and propagated.


1. Equilibrium, Reflective and Critical Finance
By and large, mainstream economics has adhered to two doctrines concerning the way in which finance operates in modern...